Complex Instruments Have Increased Risk and Reduced Performance at Mutual Funds

Abstract

We study the allowance and use of derivatives, leverage, and illiquid assets by mutual funds. We observe that an increasing number of funds are granted access to these complex instruments over our sample period. In contrast to previous studies, we find that the allowance of these complex instruments is associated with poor performance and higher risk. The underperformance is most acute during market downturns, and among mutual funds that are allowed to use derivatives. We also find that mutual funds underperform when they actually use complex instruments. Overall, our results suggest caution in allowing funds to use these complex instruments.

Keywords: mutual funds, complex instruments, leverage, derivatives, illiquid assets, borrowing, margin, short selling, options, futures, restricted securities, performance, risk

JEL Classification: G11, G23